The Dumbest Money in the World

The story of how the credit crisis came to be - and how you can profit from it in 2008...

[This is the first of two parts.  The second part will run tomorrow.]

In the past few weeks, the markets have run up strongly. Of course, this run has been mostly fueled by one thing:  Statements from Goldman Sachs Group, Inc ( GS), JPMorgan Chase & Co. ( JPM) and others who declared that their exposure to subprime mortgages and "structured products" was not dangerous.

And the traders had a field day. No more major write-downs were coming, they said, and the markets rejoiced.

Of course, this is the just the latest "credit crunch"- induced market swing. It’s hard to go a day without hearing another pundit speculate on the next worse- case scenario - or why a recession is about to crush your retirement plans.

Yet so few investors - and many of the best analysts on Wall Street - really understand how this credit crisis came to be. Or what it may portend for the coming year.

Having worked in global banking for nearly 25 years - and having gotten so many questions from readers - I’ve put together this report. No doubt, the "dumbest money in the world" created the housing bubble and the mortgage crisis. And the story below takes a circuitous path. But I think you’ll enjoy it...

The Start of a Bad Scene...

Back in August, we saw huge distress in money markets, as short-term structured investment vehicles (SIVs ) - which are cash funds sponsored mostly by major banks around the world - found themselves unable to roll over their daily funding as investors fled the asset class fearing that they could be saddled with "radioactive" exposure to subprime loans.

The sponsors and banks guaranteeing these funds were saddled with losses, and they had no liquidity in the investments in these funds. The irony of this all is that the objective of money market funds ( and the investments that go in them ) is safety and liquidity.

This crisis prompted central banks around the world, notably the European Central Bank and the U.S. Federal Reserve to inject massive amounts of liquidity, open their discount windows, and in the case of the Fed, lower interest rates. All of this in an effort to keep their banking systems and economies going. 

The resulting financial turmoil reverberated throughout the global capital markets with sell-offs in global equity and corporate bond markets. It created a "flight to safety" into sovereign debt like U.S. Treasuries. And many took refuge from a falling U.S. dollar in gold, oil and other commodities.

Surely, nobody could have prevented this, most would say.  But is this true?

The seeds of the current financial crisis were planted well before 2000...

 In 2000, as I headed credit at a major asset manager, I took precautions against each of the problems that are now blowing up.  If most other market participants had taken similar precautions, this crisis and the housing bubble could have been prevented.

And the scary thing is that all I did then was to take the trouble to double-check the spoon-fed analysis from Wall Street and the rating agencies, and question the basic assumptions in them.  And I managed to do this while I was jettisoning  WorldCom, Enron, AT&T Inc. ( ATT), Lucent Technologies and the Detroit carmakers out of the approved investment list well before their credit quality collapsed.

We realized back then that the assumptions used by rating agencies for sub-prime structured products were a stretch... And also that SIVs made little sense. 

In these "black box" investments, we would be picking up only a couple of basis points over Fed funds in yield - and taking an unquantifiable risk at the same time. 

We could not know the individual holdings of the SIV, and once a month we would get an assessment from a couple of rating agencies, telling us that the SIV was in compliance with their risk diversification and minimum credit quality of their holdings. 

It amounted to giving some trader our money so that he could cherry pick the best investment opportunities ahead of us. It also gave them the opportunity to include bad credit in the SIVs without our knowledge. And that is precisely what happened.

At the time, I approved 12 SIVs out of more than 200: those 12 had full bank guarantees. A couple of my colleagues in the industry, with much deeper staffs dedicated to this asset class, later confirmed to me that they had only 28 and 32 of these SIVs. 

So the huge question is: Who was investing in the remaining 170- plus SIVs?

We now know the answer: The Dumbest Money in the World. 

The dumbest money in the world enabled the growth of structured commercial paper to about half the size of the entire U.S. money markets. And the SIVs were the worst part of this. 

Yet one thing stands clear, financial institutions could not have originated all this structured subprime mortgage paper without greedy and careless buyers.

Where were the real estate executives, the real estate appraisers, the regulators, the bank examiners, the accountants, the financial press, the rating agencies, Wall Street, the Fed, and the discipline of the buy-side, and especially Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE)? 

No alarm signs went up. Most went for the quick buck and forgot to do the right thing.  

How could this happen to the "safe" cash market? Any fool can make a loan - the difficult part is collecting it...

Last month, GE Asset Management shocked investors when it forced them to take 96 cents on the dollar for their investments in a short-term bond fund.  Money market firms have almost always absorbed the few losses in their money market funds. 

After all, the money market funds are supposed to focus on safety and liquidity through diversified, very safe, short-term investments.  They cannot afford to "break the buck" - that is, suffer a loss of capital in their fund that requires them to mark down their net asset value below $1 per share. 

Neither can they afford to tell their clients that they cannot have their cash back on any given day. So how could this have happened? Simple...

The money market funds have a large number of clients moving cash in and out of their funds every day, during the day. Thus, they invest a very large portion of their balances overnight, so that this money is available the next day.  This requires them to reinvest a very large amount of money in a large number of transactions quickly, every day - and to avoid bad names in a blink. 

Thing is, only the best and largest money market funds have enough qualified staff to analyze all the approved names in great detail. So most rely on the rating agencies and on Wall Street guidance.  The problem with the rating agencies is that in many cases they are a coincident indicator of credit quality.  When they downgrade a credit, most probably you are already trapped in it.

So, the thinking is that when an inevitable credit event hits a name they hold, the exposure is typically minimal in size because of diversification. A nd there is usually very few days left until getting paid back . If everything else failed, the asset management company usually takes the loss themselves, rather than alienating their clients in their money market fund.

The result of having to trade in a large amount of transactions... in a very fast-moving credit market... in a highly competitive business... with low-quality analytical support... relying strongly on rating agencies... led to complacency in the vast majority of the money market participants.  Enter the banks. [In part two tomorrow, we’ll look at how banks contributed to the problem and the way ahead in 2008.]